Apache: Tighter Margins Will Hold Stock Down

Jun.27.12 | About: Apache Corporation (APA)

Apache Corporation (NYSE:APA) was recently downgraded by TheStreet Ratings from buy to hold. According to the ratings report, the company has strengths in many areas and this can be seen from the growth in revenue, the good financial position with acceptable debt levels, and the operating cash flow. However, these strengths are set off by weaknesses that include unsatisfactory net income growth and a disappointing performance by the stock.

The revenue growth at 14.9% over the same quarter of the previous year is better than the industry average of 11.9% but, despite this growth, there is a decline in earnings per share. The debt to equity ratio at 0.27 is better than the industry average showing the success of debt management but, what is of concern is that the net income has declined almost 30% from $1.1 billion to $797 million, when compared to the same quarter in the previous year.

The next few months are not going to be kind to energy stocks. The slow recovery in the U.S. economy coupled with the continuing problems in the eurozone by having the effect of diminishing demand for oil and weak prices, while the costs of exploration and production are going up. As a result, there is a decline in revenue and a squeeze on operating margins.

Apache is in the business of oil and gas exploration and production and operates in North America, Argentina, Africa, the North Sea and Australia. The company showed record earnings in 2011 of $4.5 billion (earnings per share of $11.47 per share), which was up 50% from 2010, as the company benefited from higher prices of oil that is produced in Australia, the Gulf of Mexico and the North Sea. Production continued to be strong in the first quarter of 2012, with a 6% increase in production of liquids. Revenues for the period showed an increase of 11% on a year on year basis to $4.5 billion, though earnings were down almost 30% because of a $390 million write-down of Canadian oil and natural gas assets.

Despite low gas prices in North America, the company continues to perform well because of the higher crude oil prices it receives from various such as Australia and the North Sea. It has increased its onshore drilling activities, increased production in the Permian Basin and doubled its holding in the Anadarko Basin by acquiring another 550,000 acres.

The acquisition of Cordillera Energy Partners in January, 2012 has added 245,000 acres of potential energy reserves in the Granite Wash area on the border of Texas and Oklahoma. Like many US energy producers, Apache is stepping up its drilling and exploration activities to reduce the dependence of the US on imported oil but, while domestic US production is increasing, it is not having a beneficial effect on oil and gas prices. This increased activity especially in the Permian Basin in West Texas and southeastern New Mexico is increasingly causing environmental concern. Apache and its peers Chesapeake (NYSE:CHK), Devon Energy (NYSE:DVN) and Occidental Petroleum (NYSE:OXY) are producing approximately one million barrels per day from this region.

Over the past couple of years, Apache has spent $14 billion on acquisitions in joint ventures and is now concentrating on getting the most out of this large investment. Though competitors have moved to an exclusive focus on the production of liquids, Apache is continuing to maintain a 50:50 split between liquids and natural gas - which leaves it more vulnerable to the low prices of gas in North America. Occidental Petroleum is the largest player on the Permian Basin by acreage with 3 million net acres, while Apache is second with around 1.5 million net acres. However, Apache will have to use techniques such as CO2 flooding in order to maximize its recovery from its acreage.

Recently, Apache has had good news in terms of a well that was drilled in the Beryl Field on the North Sea. It seems that Apache is getting the highest initial production rate that has been seen in some years. This seems to have vindicated Apache's decision to buy the Beryl Field and other assets from Exxon Mobil (NYSE:XOM).

In addition to the North Sea, Apache has an interest in the Western Australia Wheatstone LNG project where the primary operator is Chevron (NYSE:CVX). This product holds a lot of potential for all the companies concerned because it represents an opportunity to supply the growing LNG markets in Asia. The company is planning to produce more than one million barrels of oil equivalent by 2016 with more than 40% coming from the United States. Currently Apache's most productive assets are in Egypt.

Apache is a well-managed company and I have no doubt that with its plans in the US, it will meet its production targets. I am impressed with its international operations and, in particular, Egypt where it has been expanding steadily, despite the political instability in that country. I am also impressed with the management of capital expenditure, where the company has sought to make the most of its limited resources without going overboard on debt.

Despite its undoubted strengths, it is still vulnerable to the global demand supply situation on liquids and the weak gas prices in North America. I am neutral on the stock and would not recommend a buy unless there is more definite information on the future of crude oil and gas - which depends on factors outside the control of the company. However, I would hold on to existing investment positions in the expectation that any upturn in the energy markets will provide opportunities for capital appreciation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.